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6. the Middle-Income Trap and China's Growth Prospects 6. The Middle-Income Trap and China’s Growth Prospects Yingjie Feng and Yang Yao Introduction China reached the upper-middle income level in 2012 by the World Bank’s criterion. There has been increasing debate about whether China’s growth will be sustainable in the future. Will China follow the countries—notably, some in Latin America—that have fallen into the so-called ‘middle-income trap’: a situation in which a country’s catch-up process stops once its per capita income reaches the middle-income level? While the term ‘middle-income trap’ has been widely used, there is no precise definition of what it really means, and the understanding of the characteristics of the trap is also inadequate. This chapter is aimed at providing a general description of the middle-income trap and, drawing on the comparison between China and those successful economies in history, discusses China’s prospects of avoiding the trap. Section two provides a brief introduction to various approaches to defining the middle-income trap, and, using a case of success, Korea, as a benchmark, we show that both the relative-income criterion and the absolute-income criterion suggest the existence of this trap. Section three turns to the characteristics that distinguish those ‘successful’ economies from the ‘failed’ ones. It first provides a framework for analysis that synthesises the neoclassical economic growth model, the endogenous growth model, the structural change model and the political economy model. It then compares the successful and failed economies on several key growth drivers identified by the framework. It finds that among various economic, social and political indicators, investment, education, demographic structure, the manufacturing sector and income distribution are the most relevant to the middle-income trap. Drawing on these observations, section four compares China’s characteristics with those of successful countries in history. By and large, China is quite similar to these countries in many aspects, providing a positive outlook for China’s future growth, but some of China’s distinctions, including its exceptionally high saving and investment rates and rising income inequality, pose some potential risks to the sustainability of its economic growth. We conclude in section five. 133 Deepening Reform for China’s Long-Term Growth and Development What is the middle-income trap? The notion of the middle-income trap was proposed in a World Bank report, An East Asian Renaissance: Ideas for Economic Growth (Gill and Kharas 2008), and in Kharas and Kohli (2011). In these and other works the authors describe the middle-income trap as a situation in which ‘countries that avoid the poverty trap and grow to middle-income levels subsequently stagnate and fail to grow to advanced-country levels’ (Kharas and Kohli 2011, p. 281). A precise definition of the trap, however, is not as straightforward as it seems at first glance. We have to set an appropriate criterion for identifying the failed countries which accord with the above description, but there is always some arbitrariness behind a criterion. In general, three approaches are used in recent discussions. First, some literature relates the middle-income trap to growth slowdowns (for example, Eichengreen et al. 2013). The middle-income trap can be redefined as a phenomenon in which fast-growing economies slowed significantly before their per capita GDP reached the high-income level. Eichengreen et al. (2013) find that while there was considerable dispersion in per capita income at which slowdowns occurred, two ranges are more common: one in the range of $10 000–11 000 and the other $15 000–16 000 (2005 purchasing power parity [PPP] dollars). The growth slowdown is, however, not equivalent to the original meaning of the middle-income trap. Slowdowns could be a natural outcome of growth itself, as predicted by classic growth theory. They can also happen for cyclical reasons. What really matters is the stage at which the growth slowdown occurs. Thus, the key to tackling this problem is a definition of income levels, which forms the foundation of the next two approaches. The second approach classifies countries by their absolute per capita income and investigates their long-term transition between different income groups. The World Bank’s income classification system is the most widely used to accomplish such a task. Per capita gross national income (GNI) is considered the best single indicator of a country’s economic capacity. The Bank explains that $480, $1940 and $6000 (at 1987 price levels) were established as the original thresholds for lower-middle income, upper-middle income and high income respectively, and the Bank updates these thresholds annually according to the international inflation rate. In other words, thereal income levels defined by this method remain constant over time. 134 The Middle-Income Trap and China’s Growth Prospects Using this criterion, we describe the income transition of 104 countries (the largest set of countries with available data) between 1970 and 2010 in Figure 6.1. The horizontal axis represents real per capita GNI (in log terms) in 1970 and the vertical axis in 2010, respectively. The three horizontal lines indicate the three income thresholds described above, and so do the three vertical lines. Thus, the quadrant is divided into 16 parts, each of which represents a type of income transition. For example, China lies in the sub-area in which the first column overlaps with the third row (count from the origin), indicating that China moved from the low-income group in 1970 to the upper- middle income group in 2010. The figure shows that most countries realised growth in an absolute sense, although only 13 countries declined during this period. In comparison with the large group of countries stuck at the middle- income level, however, only 16 middle-income countries in 1970 entered the high-income group by 2010. Figure 6.1 (Absolute) Income Transition in the World, 1970–2010 Source: World Bank (2013). Despite the convenience offered by the absolute criterion, one may be concerned that this approach fails to reflect whether a less-developed country has caught up with more developed countries. A relative-income classification system provides a remedy in this sense. We define a country’s relative income as the ratio of its absolute per capita income to that of the United States; however, 135 Deepening Reform for China’s Long-Term Growth and Development a key difficulty arises when we consider how to establish the thresholds for middle-income and high-income groups. In order to reduce the arbitrariness as much as possible, we attempt to find a benchmark country which is generally believed to have successfully caught up with developed countries from a lower- income stage, and make our thresholds consistent with the relative income level of this benchmark at each stage. Korea, a case of success, may serve this purpose. The Korean economy took off in the early 1960s when its per capita income was 7 per cent of the American level. It then rose to 44 per cent of the American level in the mid 1990s when the World Bank accepted Korea as a high-income country. We then set these two levels of relative income as the thresholds for the middle-income and high-income groups, respectively. This approach tells us whether a country ever achieved Korea’s initial relative income and whether it finally reached Korea’s relative income in the mid 1990s. In short, it shows whether a country has succeeded in raising its relative income as well as Korea has achieved. Figure 6.2 presents the income transition in the world between 1960 and 2010 using the above relative criterion. The results can be explained in the same way as those of Figure 6.1. The only difference here is that we turn to using relative instead of absolute income. Among the 88 low-income or middle-income countries in 1960, only 23 raised their relative income by at least 10 percentage points, and only 12 crossed the threshold for high-income countries. In contrast, more than half failed to narrow their income gap relative to the United States. Despite the differences, the absolute-income criterion and the relative- income criterion draw some robust conclusions. First, the middle-income trap does exist. Most of the middle-income countries of 1960 or 1970 have failed to escape from this group. The exceptions are few. Japan, the ‘Four Little Dragons’ of East Asia and a few southern European countries are cases of success, while Brazil, Argentina, the Philippines and Malaysia are cases of failure. 136 The Middle-Income Trap and China’s Growth Prospects Figure 6.2 (Relative) Income Transition in the World, 1960–2010 Source: Penn World Table (PWT 8.0). What characteristics distinguish ‘successes’ from ‘failures’? Since the middle-income trap does exist for whichever criterion we use, the next question is what characteristics distinguish those successful countries from the failed ones. In this section, we compare a series of economic, social and political indicators between the two groups of countries, and summarise their key differences. Before we start the comparison, we provide a framework synthesising the neoclassical growth model, the endogenous growth model, the structural change model and the political economy model. In the standard Solow–Swan model, capital accumulation is the key driver of economic growth before a country reaches its steady state of growth. So the first set of indicators we use for our comparison includes consumption, savings and investment. Then, according to the endogenous growth model, human capital accumulation and technological change are two key drivers of economic growth. The second set of indicators we include for our comparison comprises education, health conditions and 137 Deepening Reform for China’s Long-Term Growth and Development demography in a country/region.
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